Phillips Curve Musings: Second Addendum on Keynes and the Rate of Interest

In my two previous posts (here and here), I have argued that the partial-equilibrium analysis of a single market, like the labor market, is inappropriate and not particularly relevant, in situations in which the market under analysis is large relative to other markets, and likely to have repercussions on those markets, which, in turn, will have further repercussions on the market under analysis, violating the standard ceteris paribus condition applicable to partial-equilibrium analysis. When the standard ceteris paribus condition of partial equilibrium is violated, as it surely is in analyzing the overall labor market, the analysis is, at least, suspect, or, more likely, useless and misleading.

I suggested that Keynes in chapter 19 of the General Theory was aiming at something like this sort of argument, and I think he was largely right in his argument. But, in all modesty, I think that Keynes would have done better to have couched his argument in terms of the distinction between partial-equilibrium and general-equilibrium analysis. But his Marshallian training, which he simultaneously embraced and rejected, may have made it difficult for him to adopt the Walrasian general-equilibrium approach that Marshall and the Marshallians regarded as overly abstract and unrealistic.

In my next post, I suggested that the standard argument about the tendency of public-sector budget deficits to raise interest rates by competing with private-sector borrowers for loanable funds is fundamentally misguided, because it, too, inappropriately applies the partial-equilibrium analysis of a narrow market for government securities, or even a more broadly defined market for loanable funds in general.

That is a gross mistake, because the rate of interest is determined in a general-equilibrium system along with markets for all long-lived assets, embodying expected flows of income that must be discounted to the present to determine an estimated present value. Some assets are riskier than others and that risk is reflected in those valuations. But the rate of interest is distilled from the combination of all of those valuations, not prior to, or apart from, those valuations. Interest rates of different duration and different risk are embeded in the entire structure of current and expected prices for all long-lived assets. To focus solely on a very narrow subset of markets for newly issued securities, whose combined value is only a small fraction of the total value of all existing long-lived assets, is to miss the forest for the trees.

What I want to point out in this post is that Keynes, whom I credit for having recognized that partial-equilibrium analysis is inappropriate and misleading when applied to an overall market for labor, committed exactly the same mistake that he condemned in the context of the labor market, by asserting that the rate of interest is determined in a single market: the market for money. According to Keynes, the market rate of interest is that rate which equates the stock of money in existence with the amount of money demanded by the public. The higher the rate of interest, Keynes argued, the less money the public wants to hold.

Keynes, applying the analysis of Marshall and his other Cambridge predecessors, provided a wonderful analysis of the factors influencing the amount of money that people want to hold (usually expressed in terms of a fraction of their income). However, as superb as his analysis of the demand for money was, it was a partial-equilibrium analysis, and there was no recognition on his part that other markets in the economy are influenced by, and exert influence upon, the rate of interest.

What makes Keynes’s partial-equilibrium analysis of the interest rate so difficult to understand is that in chapter 17 of the General Theory, a magnificent tour de force of verbal general-equilibrium theorizing, explained the relationships that must exist between the expected returns for alternative long-lived assets that are held in equilibrium. Yet, disregarding his own analysis of the equilibrium relationship between returns on alternative assets, Keynes insisted on explaining the rate of interest in a one-period model (a model roughly corresponding to IS-LM) with only two alternative assets: money and bonds, but no real capital asset.

A general-equilibrium analysis of the rate of interest ought to have at least two periods, and it ought to have a real capital good that may be held in the present for use or consumption in the future, a possibility entirely missing from the Keynesian model. I have discussed this major gap in the Keynesian model in a series of posts (here, here, here, here, and here) about Earl Thompson’s 1976 paper “A Reformulation of Macroeconomic Theory.”

Although Thompson’s model seems to me too simple to account for many macroeconomic phenomena, it would have been a far better starting point for the development of macroeconomics than any of the models from which modern macroeconomic theory has evolved.


18 Responses to “Phillips Curve Musings: Second Addendum on Keynes and the Rate of Interest”

  1. 1 Henry Rech July 11, 2019 at 4:14 am


    Isn’t Chapter 17 just making the argument that fiat money is not same as commodity money?

    It has different characteristics which make it unique.

    General Equilibrium Theory is the theory of the optimal allocation of scarce resources among competing uses. It is not a theory about the level of the utilization of resources. That is why it cannot constitute a macroeconomic theory.

    Capital theory deals with the allocation of limited financial resources among competing capital assets. It is similarly not a theory about the level of capital goods production. That is why such a theory won’t be found in Keynes’ macroeconomic model.

  2. 2 Henry Rech July 11, 2019 at 7:21 am

    One further thought.

    In Keynes’ world the rate of interest is not the mechanism by which resources are allocated intertemporarily. It is the mechanism (with expectations as a parameter) by which the level of capital goods production is determined.

    The rate of interest in the GE model is not comparable with the rate of interest found in the GT.

  3. 3 Henry Rech July 11, 2019 at 7:30 am

    I think I mean intertemporally, not intertemporarily. 🙂

  4. 4 David Glasner July 11, 2019 at 8:26 am

    Henry, We have been through this all before, so I will be brief. I view general-equilibrium theory as a method of taking into account the complexity and interdependence of economic activity. You may be right in your explanation of Keynes’s thought process, but that does not justify it. The rate of interest is an intertemporal price and Keynes in chapter 17 recognizes it as such. His explanation of interest in the GT as pure liquidity preference is simply indefensible, and I say that as an admirer of his contributions to economics

  5. 5 Rob Rawlings July 11, 2019 at 10:08 am

    While Keynes appears to have been deficient in spelling it out there is not necessarily a contradiction between claiming that ‘the market rate of interest is that rate which equates the stock of money in existence with the amount of money demanded by the public’, and that a ‘relationships …. must exist between the expected returns for alternative long-lived assets that are held in equilibrium’. In other words a major (but not the only) factor in people’s desire to hold money (either as a cash balance or in order to loan it out) will be the alternative returns available if they held their wealth in other forms.

    If the money rate of interest is too low compared to the alternatives available
    then a simple adjustment mechanism would be for people to attempt to move out of money and drive up the price level. With the resulting lower ‘real’ quantity of money higher interest rates on money will be needed to ‘equate the stock of money in existence with the amount of money demanded by the public’, which will (when it reached the appropriate level) equilibrate the money rate of interest with returns available elsewhere.

  6. 6 Inal July 11, 2019 at 11:20 am

    Very ingeniously, David, although some economists like M. G. Hayes [Hayes 2010] will probably defend Keynes on the grounds that:

    “…principle of effective demand, the backbone of The General Theory,
    represents an alternative definition of equilibrium.
    [Modern] …loanable funds theory can be no more separated from the
    Walrasian concept of general equilibrium than Keynes’s liquidity-preference theory can be
    from the principle of effective demand. Since these two concepts of system equilibrium are
    structural incompatible, it is no surprise that the loanable funds debate has been at cross-


    The loanable funds fallacy: saving, finance and equilibrium
    M. G. Hayes
    Cambridge Journal of Economics
    Vol. 34, No. 4 (July 2010)

  7. 7 Biagio Bossone July 12, 2019 at 1:12 am

    “The current rate of interest depends, as we have seen, not on the strength of the desire to hold wealth, but on the strengths of the desire to hold it in liquid and illiquid forms respectively, coupled with the amount of the supply of wealth in the one form relatively to the supply of it in the other.” (JM Kyenes, Collecgted Writings VII, p 213)

    It is not at all the case that Keynes asserted that the rate of interest is determined in a single market (the market for money).

    He understood money in a much broader sense (in fact, he spoke about “liquidity” preference), and was not concerned solely with the demand for money. The theory of liquidity preference is concerned with the demand for assets of various degrees of liquidity, and the rate of interest depends on both the demand for and supplies of assets across the whole of this spectrum.

    Liquidity preference is the decision about the degree of liquidity at which savings should be held. It is a decision concerning the stock of savings – wealth – at any point in time and its composition, rather than any new flow of saving alone or the stock of any particular asset called money.

    And the rate of interest is not determined by the supply of and demand for (flows of) saving or the supply of and demand for the stock of one particular asset called money, but by the supply of and demand for all assets into which holdings of (stocks of) wealth can be placed. Money is just one of these assets.

    Why is all this so “undefensible”, as you say?

  8. 8 Biagio Bossone July 12, 2019 at 4:05 am

    In practice, the interest earned on assets held as stores of value is the reward for their relative illiquidity and can alternatively be seen as a premium on liquidity.

    According to Keynes’ liquidity preference theory (LPT), money is a store of value, liquidity may include money as well as non-money liquid assets, and wealth allocation decisions are made by comparing all existing assets based on the cost to exchange them and their capacity to protect the value stored in them.

    The interest rate, therefore, rests on a general equilibrium analysis of the whole spectrum of assets across the domestic and international economy (in the case of international financially integrated and open economies).

    Essentially based, as it is, on preferences toward liquidity (vs illiquidity), LPT, by its very construction, cannot be a partial equilibrium analysis and must on the contrary reflect a general equilibrium approach.

  9. 9 Biagio Bossone July 12, 2019 at 4:59 am

    Finally, as regards the interest rate and capital assets, in the General Theory Keynes clarified that, “investment depends on a comparison between the marginal efficiency of capital and the rate of interest” (JMK, Collected Writings VII, p 151, fn 1), and denied any unique and stable relationship between debt and equity markets.

    His account of “spot-the-convention-type” of asset-market play in Chapter 12 is clearly relevant to securities and derivative markets in general, including also FX and property markets, etc.

    LPT is indeed a theory of asset prices more generally, not just of the price of one asset in one market.

  10. 10 David Glasner July 12, 2019 at 5:54 am

    Biaggio, Many thanks for your very astute comments.I completely agree that the theory of liquidity preference can be expressed in an appropriate general equilibrium framework, as Keynes himself in chapter 17 and elsewhere did. My point is that he sometimes lapsed from that appropriate general equilibrium view of interest into a more extreme partial equilibrium view in which liquidity preference became the sole factor explaining the essence of the rate of interest which then governed his application of the simplified model (IS-LM) and governed his applied analysis in an aggregated macro model.

  11. 11 Biagio Bossone July 12, 2019 at 7:27 am

    Totally agree, David. Many thanks for your reply!

  12. 12 Henry Rech July 16, 2019 at 12:56 am

    David, Biagio,

    I don’t believe there is any question of Keynes taking a partial or general equilibrium approach in the GT. Keynes was concerned with how changes in income and spending shift the equilibrium level of output and employment.

    Relative price changes (that is partial or general equilibrium analysis), in his world, have no relevance to macroeconomic considerations, other than perhaps where output was at the full employment level.

    That there might be a panoply of financial assets with characteristics of near money was not of critical interest to him, even though their existence might have been considered or implied in his analysis.

  13. 13 Biagio Bossone July 16, 2019 at 6:51 am


    By combining 1) the theory of consumption (determined as a fraction of current income), 2) animal spirits (as the fundamental source of irreducible or radical uncertainty underpinning the process of capital accumulation), and 3) liquidity preference theory (LPT) (to explain the rate of interest as a “highly conventional…phenomenon” – to use his own words), JMK intended to demonstrate that capitalist economies may be charcaterized by permanent states of underemployment equilibrium.

    You may not refer to Keynes’ analysis as General Equilibrium; in fact, one might call it General Disequilibirum Analysis (where disequilibrium may persist due to the lack of endogenous incentives to eliminate it). Yet Keynes’ analysis involved all relevant markets in the economy and it was certainly not partial equilibrium analysis. In this sense, “general” is used as opposed to “partial,” and not on whether the underlying adjustment mechanism is based on quantities rather rather than prices.

  14. 14 Biagio Bossone July 16, 2019 at 6:53 am


    In an earlier comment, you had noted (correctly, in my view) that “in Keynes’ world the rate of interest…is the mechanism (with expectations as a parameter) by which the level of capital goods production is determined.” If you re-read carefully what I wrote in my comments, you will notice that a) they are consistent with that statement and b) they nowhere suggest that Keynes was concerned with “a panoply of financial assets with characteristics of near money”.

    Keynes’ use of the term “liquidity” indicates that he was not concerned exclusively with the demand for money; he considered the demand for assets of various degrees of liquidity, and in his LPT the rate of interest depends on both the demand for and supplies of assets across the whole of this spectrum.

    “Money,” however, does have a particularly crucial role in LPT and, more broadly, in Keynes’ general (dis)equilibrium approach; while illiquid assets offer holders a reward in the form of interest, the reward for holding money is the essence of liquidity itself: the rate of interest is the price of illiquidity.

    To such extent, and to the extent that such a price determines the level of capital accumulation (and hence of future wealth creation), it inevitably plays a key role also in the economy’s process of intertemporal resource allocation. In fact, one cannot (I would even say, “may not”) think of Keynes’ interest rate theory as disjointed from its intertemporal dimension: time and the uncertainty that comes with it are of the essence in Keynes’ view of the inherent instability of a monetary production economy.

    In Keynes, time, uncertainty, and liquidity are essentially interwoven.

  15. 15 David Glasner July 16, 2019 at 8:45 am

    Henry and Biagio, I think Keynes at his best was reasoning in terms of a complex intertemporal general-equilibrium system in which markets are all interrelated but are not necessarily in equilibrium and the equilibrating forces are not necessarily very powerful. But to make his system tractable he also argued in terms of a highly aggregated model single period model that was not capable of accommodating the full complexity of the relationships underlying his analysis. My criticism of Keynes focuses mainly on his overly aggregated and overly simplified one period model, not his more complex understanding of how the economy works.

  16. 16 Biagio Bossone July 16, 2019 at 10:14 am


    I think you are right and I tend to share your criticism (with all the humbleness that I feel due in being critical of such a gigantic master).
    But while Keynes’ highly aggregate model was incapable of accommodating the full complexity of his vision, as you say, he did point to a fundamental way of how to turn (neo)classical economics on its head, and most of all he recognised that this was in fact necessary in order for Economics to become a useful social discipline.

    The troubles of Economics, today, derive from the ineptitude of Keynes’ followers to build on his extraordinary intuition and complete what he was unable to complete, and the inability of contemporary economists to combine – as he successfully did – a vast theoretical knowledge with a high sense of realism and history.

  17. 17 Henry Rech July 16, 2019 at 11:53 am


    The word :”general” is problematic in the sense that it appears in the title of Keynes book and in part forms the name given to a theory of optimal resource allocation (General Equilibrium Theory – GET). So we have to be careful not to mix the two uses of the word. Keynes meant by “general” that he was considering all possible macro equilibrium points whereas the “general” in the GET applies to all markets in simultaneous equilibrium at only one point, viz., full employment.

    I’m sure I’m not telling you anything new, but we have to be careful not to mix the two meanings as you almost seem to be doing above (?).

    So while Keynes used the word “general” he of course was not referring to GET.

    And I don’t agree that Keynes theory might have implications for intertemporal resource allocation. He was interested in the level of capital goods production in a given period. And in any event, it is relative prices which are the mechanism by which capital is allocated across time, not “price”.

    Keynes specifically stated that the rate of interest was not the reward for not spending now but the reward for not hoarding. This is where the notion of liquidity preference is unique and plays into the question of uncertainty.

    There was an intertemporal dimension to Keynes’ theorizing but not in the sense of optimal resource allocation.

  18. 18 Henry Rech July 16, 2019 at 12:05 pm


    Keynes was concerned with how an economy could be stable at levels of output and employment below the full employment level. He argued that the process of adjustment was driven by changes in income and spending not changes in relative prices (the mechanism of the GET). These are entirely two different adjustment mechanisms.

    Whilst some of the elements of Keynes theory may have been “in the air” prior to the GT, he added to these elements and combined them in such a way that he could explain how an economy could be stable at a level of output below full employment.

    This was the genius of Keynes and the essence of his revolution. A mantle unreasonably denied him by people like David Laidler. (I’m referring to Laidler’s ambiguously titled “Fabricating the Keynesian Revolution”).

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.


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